CHAPTER 2 BASIC ACCOUNTING CONCEPTS

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1 CHAPTER 2 BASIC ACCOUNTING CONCEPTS CLASS DISCUSSION QUESTIONS 1. The basic elements of a financial accounting system include (1) a set of rules for determining what, when, and the amount that should be recorded; (2) a framework for preparing financial statements; and (3) one or more controls to determine whether errors may have occurred in the recording process. These elements apply to all businesses, from a local restaurant to Google Inc. All businesses require a financial reporting system so that financial statements can be provided to stakeholders. 2. a. Purchase of land for cash affects only assets. b. Payment of a liability affects assets and liabilities; receipt of cash for fees earned affects assets and stockholders equity. c. Incurring an expense that is partially paid in cash decreases assets, increases liabilities, and decreases stockholders equity (retained earnings). For example, assume that a business hires a lawyer for $10,000 to draft and file the necessary documents to start and incorporate the business. The business pays the lawyer $4,000 and agrees to pay the remaining $6,000 over the next several months. This transaction would decrease assets ($4,000), increase liabilities ($6,000), and decrease stockholders equity (retained earnings) $10,000. The expense is an organizational expense. Likewise, a new business might hire a new chief operating officer by agreeing to pay a nonrefundable, noncancellable signing bonus of $50,000, with $30,000 due at signing and the remainder due in four installments. This transaction would decrease assets ($30,000), increase liabilities ($20,000), and decrease stockholders equity (retained earnings) $50,000. The expense is salary expense or bonus expense. 3. Out of balance. Assets are correct, but retained earnings (utilities expense) should have been decreased by $1,200 rather than $2,100. Thus, retained earnings is understated by $900, and total liabilities plus stockholders equity would be less than total assets by $ a. Out of balance. Assets are overstated by $27,000 ($85,000 $58,000), and thus, total assets would exceed total liabilities plus stockholders equity by $27,000. b. In balance. Even though liabilities and stockholders equity are incorrect, the accounting equation balances. For this error, liabilities are overstated by $7,000, and retained earnings (fees earned) are understated by $7,000; thus, the over- and understatements offset each other, and the accounting equation balances. 5. A primary control for determining the accuracy of record keeping is the equality of the accounting equation. The accounting equation must balance. 6. Total assets are increased by $175,000: an increase in cash of $375,000 and a decrease in land of $200,000. Stockholders equity (retained earnings) is increased by $175,000, the gain on the sale of the land. 7. a. The payment of $15,000 of dividends decreases total assets (decrease in cash) and decreases stockholders equity (decrease in retained earnings). b. Net income is not affected by the payment of dividends. Dividends are a distribution of income to stockholders and are not an expense. 8. a. The equality of the accounting equation would not be affected. That is, the accounting equation would still balance. b. On the income statement, total operating expenses (salary expense) would be overstated by $30,000, and net income would be understated by $30,000. On the retained earnings statement, the beginning and ending retained earnings would be correct. However, net income and dividends would be understated by $30,000. These understatements offset one another, and thus, ending retained earnings is correct. The balance sheet is not affected by the error. On the statement of cash flows, net cash flows from operating activities is understated, since cash paid for salary expense is overstated. In addition, net cash flows from 31

2 financing activities is overstated, since cash paid for dividends is understated. The understatement of net cash flows from operating activities is offset by the overstatement of net cash flows from financing activities, and thus, the net increase or decrease in cash for the period is correct, as is the ending cash balance. 9. a. The equality of the accounting equation would not be affected. That is, the accounting equation would still balance. b. On the income statement, revenues (fees earned) would be overstated by $75,000, and net income would be overstated by $75,000. On the retained earnings statement, the beginning retained earnings would be correct. However, net income and ending retained earnings would be overstated by $75,000. The balance sheet total assets is correct. However, liabilities (notes payable) is understated by $75,000, and stockholders equity (retained earnings) is overstated by $75,000. The understatement of liabilities is offset by the overstatement of stockholders equity, and thus, total liabilities and stockholders equity is correct. On the statement of cash flows, net cash flows from operating activities is overstated, since cash received from fees earned is overstated. In addition, net cash flows from financing activities is understated, since cash received from borrowing (notes payable) is understated. The overstatement of net cash flows from operating activities is offset by the understatement of net cash flows from financing activities, and thus, the net increase or decrease in cash for the period is correct, as is the ending cash balance. 10. a. $350,000 ($500,000 $150,000) b. Stockholders equity as of December 31, 20Y8... $400,000 Less stockholders equity as of January 1, 20Y ,000 Net income... $ 50, Change in stockholders equity (see Question 10)... $50,000 Plus dividends... 18,000 Net income... $68,000 32

3 EXERCISES E2 1 a. $1,000,000 ($250,000 + $750,000) b. $350,000 ($480,000 $130,000) c. $107,500 ($115,000 $7,500) E2 2 a. $37,385 ($72,124 $34,739) b. $400 increase ($2,774 $2,374) c. Total assets = $74,898 ($72,124 + $2,774) Total liabilities = $35,139 ($34,739 + $400) Total stockholders equity = $39,759 ($37,385 + $2,374) d. Yes. [$74,898 (total assets) = $35,139 (total liabilities) + $39,759 (total stockholders equity)] E2 3 a. $1,088 ($6,862 $5,774) b. $190 decrease ($332 $142) c. Total assets = $6,530 ($6,862 $332) Total liabilities = $5,632 ($5,774 $142) Total stockholders equity = $898 ($1,088 $190) d. Yes. [$6,530 (total assets) = $5,632 (total liabilities) + $898 (total stockholders equity)] 33

4 E2 4 (a) $11,610 ($14,429 $2,819) (b) $46,241 ($57,851 $11,610) (c) $72,574 ($57,851 + $14,723) (d) $58,145 ($72,574 $14,429) or ($46,241 + $11,904) (e) $220,005 ($230,461 $10,456) or ($86,912 + $133,093) (f) $133,093 ($144,553 $11,460) or ($220,005 $86,912) (g) $10,456 ($11,460 $1,004) (h) $(1,004) ($85,908 $86,912) (i) $144,553 ($230,461 $85,908) E2 5 a. $550,000 ($750,000 $200,000) b. $635,000 ($550,000 + $125,000 $40,000) c. $434,000 ($550,000 $80,000 $36,000) d. $715,000 ($550,000 + $140,000 + $25,000) e. Net income: $130,000 ($950,000 $270,000 $550,000) 34

5 E2 6 a. (3) No effect b. (3) No effect c. (1) Increase d. (3) No effect e. (2) Decrease f. (2) Decrease g. (2) Decrease h. (1) Increase i. (1) Increase j. (2) Decrease E2 7 a. Increases assets and increases stockholders equity. b. Decreases assets and decreases stockholders equity. c. Increases assets and increases liabilities. d. Increases assets and increases stockholders equity. e. Increases assets and decreases assets. E2 8 (1) Total assets decreased $5,000. (2) Total liabilities decreased $120,000. (3) Stockholders equity increased $115,000. E (a) increase 2. (a) increase 3. (b) decrease 4. (b) decrease 5. (b) decrease 35

6 E (c) 2. (e) 3. (e) 4. (c) 5. (a) 6. (c) 7. (d) 8. (a) 9. (e) 10. (e) E2 11 a. (1) Sale of catering services for cash, $28,000. (2) Purchase of land for cash, $20,000. (3) Payment of expenses, $18,000. (4) Payment of cash dividends, $1,000. b. $11,000 ($40,000 $29,000) c. $9,000 ($109,000 $100,000) d. $10,000 ($28,000 $18,000) e. $9,000 ($10,000 $1,000) f. $10,000 ($28,000 $18,000) g. $20,000 used for purchase of land h. $1,000 used for payment of dividends E2 12 It would be incorrect to say that the business had incurred a net loss of $8,000. The excess of the dividends over the net income for the period is a decrease in the amount of retained earnings in the corporation. 36

7 E2 13 Company Sierra Stockholders equity at end of year ($770,000 $294,000)... $476,000 Stockholders equity at beginning of year ($490,000 $175,000) ,000 Net income (increase in stockholders equity)... $161,000 Company Tango Increase in stockholders equity (as determined for Sierra)... $161,000 Add dividends... 55,000 Net income... $216,000 Company Yankee Increase in stockholders equity (as determined for Sierra)... $161,000 Deduct issuance of additional capital stock... 75,000 Net income... $ 86,000 Company Zulu Increase in stockholders equity (as determined for Sierra)... $161,000 Deduct issuance of additional capital stock... 75,000 $ 86,000 Add dividends... 55,000 Net income... $141,000 37

8 E2 14 In each case, solve for a single unknown, using the following equation: Stockholders equity (beginning) + Issuance of Capital Stock Dividends + Revenues Expenses = Stockholders equity (ending) Carbon Stockholders equity at end of year ($495,000 $160,000)... $335,000 Stockholders equity at beginning of year ($333,000 $118,000). 215,000 Increase in stockholders equity... $120,000 Deduct increase due to net income ($90,000 $39,000)... 51,000 $ 69,000 Add dividends... 7,500 Additional issuance of capital stock... (a) $ 76,500 Krypton Stockholders equity at end of year ($350,000 $110,000)... $240,000 Stockholders equity at beginning of year ($250,000 $130,000). 120,000 Increase in stockholders equity... $120,000 Add dividends... 16,000 $136,000 Deduct additional issuance of capital stock... 50,000 Increase due to net income... $ 86,000 Add expenses... 64,000 Revenue... (b) $150,000 Fluorine Stockholders equity at end of year ($90,000 $80,000)... $ 10,000 Stockholders equity at beginning of year ($100,000 $76,000).. 24,000 Decrease in stockholders equity... $ (14,000) Deduct decrease due to net loss ($115,000 $122,500)... (7,500) $ (6,500) Deduct additional issuance of capital stock... 10,000 Dividends... (c) $ (16,500) Radium Stockholders equity at end of year ($248,000 $136,000)... $112,000 Add decrease due to net loss ($112,000 $128,000)... 16,000 $128,000 Add dividends... 60,000 Stockholders equity at beginning of year... $188,000 Deduct additional issuance of capital stock... 40,000 $148,000 Add liabilities at beginning of year ,000 Assets at beginning of year... (d) $268,000 38

9 E2 15 a. $3,492 ($28,236 $24,744) b. The net cash flows used for investing activities is determined by solving the following equation: Net decrease in cash = Net cash flows from operating activities + Net cash flows used for investing activities + Net cash from financing activities $61 = $5,527 + Net cash flows used for investing activities + $578 Net cash flows used for investing activities = $61 $5,527 $578 Net cash flows used for investing activities = $6,166 E2 16 a. ABBY S INTERIORS Balance Sheet October 31, 20Y6 Assets Cash... $ 50,000 Land ,000 Total assets... $550,000 Liabilities Notes payable... $200,000 Stockholders Equity Capital stock... $ 75,000 Retained earnings ,000 Total stockholders equity ,000 Total liabilities and stockholders equity... $550,000 39

10 E2 16, Concluded ABBY S INTERIORS Balance Sheet November 30, 20Y6 Assets Cash... $175,000 Land ,000 Total assets... $750,000 Liabilities Notes payable... $250,000 Stockholders Equity Capital stock... $ 90,000 Retained earnings ,000 Total stockholders equity ,000 Total liabilities and stockholders equity... $750,000 b. Retained earnings, November 30, 20Y6... $410,000 Retained earnings, October 31, 20Y ,000 Increase in retained earnings... $135,000 Add dividends... 12,000 Net income... $147,000 c. Net cash flows from operating activities = $147,000 = $125,000 + $75,000 $53,000 d. $75,000, used for the increase in the land e. $53,000, the increase in capital stock of $15,000 plus the increase in notes payable of $50,000 less the dividends of $12,000 f. $125,000 ($175,000 $50,000) 40

11 E2 17 BENJAMIN REALTY INC. Income Statement For the Month Ending April 30, 20Y9 Revenues: Sales commissions... $145,000 Expenses: Salaries expense... $75,000 Utilities expense... 15,000 Rent expense... 5,000 Interest expense... 2,000 Miscellaneous expense... 3,000 Total expenses ,000 Net income... $ 45,000 E2 18 BENJAMIN REALTY INC. Retained Earnings Statement For the Month Ending April 30, 20Y9 Net income... $ 45,000 Less dividends... 10,000 Retained earnings, April 30, 20Y9... $ 35,000 41

12 E2 19 BENJAMIN REALTY INC. Balance Sheet April 30, 20Y9 Assets Cash... $ 53,000 Land... 42,000 Total assets... $ 95,000 Liabilities Notes payable... $ 35,000 Stockholders Equity Capital stock... $25,000 Retained earnings... 35,000 Total stockholders equity... 60,000 Total liabilities and stockholders equity... $ 95,000 E2 20 BENJAMIN REALTY INC. Statement of Cash Flows For the Month Ending April 30, 20Y9 Cash flows from operating activities: Cash receipts from operating activities... $ 145,000 Deduct cash payments for operating activities... (100,000) Net cash flows from operating activities... $ 45,000 Cash flows used for investing activities: Cash payments for land... (42,000) Cash flows from financing activities: Cash receipts from issuing capital stock... $ 25,000 Cash receipts from issuing notes payable... 35,000 Cash payments for dividends... (10,000) Net cash flows from financing activities... 50,000 Net increase in cash during April... $ 53,000 Cash as of April 1, 20Y Cash as of April 30, 20Y9... $ 53,000 42

13 E2 21 a. Decrease in assets and decrease in stockholders equity. b. Increase in assets and decrease in assets. c. Increase in assets and increase in stockholders equity. d. Increase in assets and increase in liabilities. e. Increase in assets and increase in stockholders equity. f. Decrease in assets and decrease in stockholders equity. g. Decrease in assets and decrease in stockholders equity. h. Increase in assets, decrease in assets, and increase in stockholders equity. i. Decrease in assets and decrease in stockholders equity. j. Decrease in assets and decrease in stockholders equity. k. Decrease in assets and decrease in liabilities. l. Decrease in assets and decrease in stockholders equity. E2 22 a. operating section b. investing section c. financing section d. financing section e. operating section f. operating section g. operating section h. investing section i. operating section j. operating section k. financing section l. financing section 43

14 PROBLEMS P Statement of Balance Sheet Income Cash Flows Assets = Liabilities + Stockholders Equity Statement Notes Capital Retained Cash + Land = Payable + Stock + Earnings a. Investment 50,000 50,000 b. Issued note payable 25,000 25,000 Balances 75,000 25,000 50,000 c. Fees earned 28,000 28,000 c. Balances 103,000 25,000 50,000 28,000 d. Rent expense 3,000 3,000 d. Balances 100,000 25,000 50,000 25,000 e. Paid expenses 2,700 2,700 e. Balances 97,300 25,000 50,000 22,300 f. Paid salary expense 4,200 4,200 f. Balances 93,100 25,000 50,000 18,100 g. Paid interest expense g. Balances 93,000 25,000 50,000 18,000 h. Purchased land 55,000 55,000 Balances 38,000 55,000 25,000 50,000 18,000 i. Paid dividends 4,000 4,000 Balances, March 31 34,000 55,000 25,000 50,000 14,000 Statement of Cash Flows Income Statement a. Financing 50,000 c. Fees earned 28,000 b. Financing 25,000 d. Rent expense 3,000 c. Operating 28,000 e. Auto expense 1,800 d. Operating 3,000 e. Misc. expense 900 e. Operating 2,700 f. Salary expense 4,200 f. Operating 4,200 g. Interest expense 100 g. Operating 100 Net income 18,000 h. Investing 55,000 i. Financing 4,000 Increase in cash 34, Stockholders equity is the right of stockholders to the assets of the business. These rights are increased by stockholders investments and revenues and decreased by dividends and expenses. 44

15 P2 1, Continued 3. JORDAN INSURANCE INC. Income Statement For the Month Ending March 31, 20Y5 Revenues: Fees earned... $ 28,000 Expenses: Salary expense... $4,200 Rent expense... 3,000 Auto expense... 1,800 Interest expense Miscellaneous expense Total expenses... 10,000 Net income... $ 18,000 JORDAN INSURANCE INC. Retained Earnings Statement For the Month Ending March 31, 20Y5 Net income... $ 18,000 Less dividends... 4,000 Retained earnings, March 31, 20Y5... $ 14, JORDAN INSURANCE INC. Balance Sheet March 31, 20Y5 Assets Cash... $ 34,000 Land... 55,000 Total assets... $ 89,000 Liabilities Notes payable... $ 25,000 Stockholders Equity Capital stock... $50,000 Retained earnings... 14,000 Total stockholders equity... 64,000 Total liabilities and stockholders equity... $ 89,000 45

16 P2 1, Concluded 5. JORDAN INSURANCE INC. Statement of Cash Flows For the Month Ending March 31, 20Y5 Cash flows from operating activities: Cash receipts from operating activities... $ 28,000 Deduct cash payments for operating activities... (10,000) Net cash flows from operating activities... $ 18,000 Cash flows used for investing activities: Cash payment for land... (55,000) Cash flows from financing activities: Cash receipts from issuing capital stock... $ 50,000 Cash receipts from issuing note payable... 25,000 Cash payments for dividends... (4,000) Net cash flows from financing activities... 71,000 Net increase in cash during March... $ 34,000 Cash as of March 1, 20Y Cash as of March 31, 20Y5... $ 34,000 46

17 P UP-DATE COMPUTER SERVICES Income Statement For the Month Ended August 31, 20Y4 Fees earned... $27,000 Operating expenses: Salaries expense... $4,600 Rent expense... 2,500 Automobile expense... 1,200 Miscellaneous expense Total operating expenses... 9,000 Net income... $18, UP-DATE COMPUTER SERVICES Retained Earnings Statement For the Month Ended August 31, 20Y4 Net income for August... $18,000 Less dividends... 3,000 Retained earnings, August 31, 20Y4... $15, UP-DATE COMPUTER SERVICES Balance Sheet August 31, 20Y4 Assets Cash... $10,000 Land... 40,000 Total assets... $50,000 Liabilities Notes payable... $10,000 Stockholders Equity Capital stock... $25,000 Retained earnings... 15,000 Total stockholders equity... 40,000 Total liabilities and stockholders equity... $50,000 47

18 P2 2, Concluded 4. UP-DATE COMPUTER SERVICES Statement of Cash Flows For the Month Ended August 31, 20Y4 Cash flows from operating activities: Cash receipts from operating activities... $27,000 Deduct cash payments for operating activities... (9,000) Net cash flows from operating activities... $ 18,000 Cash flows used for investing activities: Cash payments for land... (40,000) Cash flows from financing activities: Cash receipts from issuing capital stock... $25,000 Cash receipts from issuing notes payable... 10,000 Cash payments for dividends... (3,000) Net cash flows from financing activities... 32,000 Net increase in cash during August... $ 10,000 Cash as of August 1, 20Y Cash as of August 31, 20Y4... $ 10,000 48

19 P HARGROVE SERVICES, INC. Income Statement For the Year Ending May 31, 20Y7 Revenues: Fees earned... $300,000 Expenses: Salaries expense... $ 87,000 Utilities expense... 40,000 Rent expense... 28,000 Taxes expense... 22,000 Interest expense... 2,000 Miscellaneous expense... 8,000 Total expenses ,000 Net income... $113, HARGROVE SERVICES, INC. Retained Earnings Statement For the Year Ending May 31, 20Y7 Net income... $113,000 Less dividends... 13,000 Retained earnings, May 31, 20Y7... $100,000 49

20 P2 3, Concluded 3. HARGROVE SERVICES, INC. Balance Sheet May 31, 20Y7 Assets Cash... $ 62,000 Land... 98,000 Total assets... $ 160,000 Liabilities Notes payable... $ 30,000 Stockholders Equity Capital stock... $ 30,000 Retained earnings ,000 Total stockholders equity ,000 Total liabilities and stockholders equity... $ 160, HARGROVE SERVICES, INC. Statement of Cash Flows For the Year Ending May 31, 20Y7 Cash flows from operating activities: Cash receipts from operating activities... $ 300,000 Deduct cash payments for operating activities... (187,000) Net cash flows from operating activities... $ 113,000 Cash flows used for investing activities: Cash payments for land... (98,000) Cash flows from financing activities: Cash receipts from issuing capital stock... $ 30,000 Cash receipts from issuing notes payable... 30,000 Cash payments for dividends... (13,000) Net cash flows from financing activities... 47,000 Net increase in cash during the year... $ 62,000 Cash as of June 1, 20Y Cash as of May 31, 20Y7... $ 62,000 50

21 P HARGROVE SERVICES, INC. Income Statement For the Year Ending May 31, 20Y8 Revenues: Fees earned... $515,000 Expenses: Salaries expense... $155,000 Utilities expense... 52,000 Rent expense... 36,000 Taxes expense... 28,000 Interest expense... 3,000 Miscellaneous expense... 11,000 Total expenses ,000 Net income... $230, HARGROVE SERVICES, INC. Retained Earnings Statement For the Year Ending May 31, 20Y8 Retained earnings, June 1, 20Y7... $100,000 Net income... $230,000 Less dividends... 40,000 Increase in retained earnings ,000 Retained earnings, May 31, 20Y8... $290,000 51

22 P2 4, Concluded 3. HARGROVE SERVICES, INC. Balance Sheet May 31, 20Y8 Assets Cash... $145,000 Land ,000 Total assets... $385,000 Liabilities Notes payable... $ 40,000 Stockholders Equity Capital stock... $ 55,000 Retained earnings ,000 Total stockholders equity ,000 Total liabilities and stockholders equity... $385, HARGROVE SERVICES, INC. Statement of Cash Flows For the Year Ending May 31, 20Y8 Cash flows from operating activities: Cash receipts from operating activities... $ 515,000 Deduct cash payments for operating activities... (285,000) Net cash flows from operating activities... $ 230,000 Cash flows used for investing activities: Cash payment for land... (142,000) Cash flows from financing activities: Cash receipts from issuing capital stock... $ 25,000 Cash receipts from issuing notes payable... 10,000 Cash payments for dividends... (40,000) Net cash flows used for financing activities... (5,000) Net increase in cash during the year... $ 83,000 Cash as of June 1, 20Y ,000 Cash as of May 31, 20Y8... $ 145,000 52

23 P2 5 a. $125,000 (net income for December of $57,500 plus total operating expenses of $67,500; also, the amount of cash received from customers on the statement of cash flows.) b. $10,620 ($67,500 $33,120 $18,000 $1,800 $3,960) c. $57,500 ($125,000 $67,500); also, see the net income for December on the retained earnings statement. d. $0 (There is no beginning retained earnings, since December was the first month of operation.) e. $12,000 (See the cash dividends on the statement of cash flows.) f. $45,500 ($57,500 $12,000) g. $45,500 ($0 + $45,500) h. $50,500 ($225,500 $175,000) i. $75,000 (See the cash received from capital stock on the statement of cash flows.) j. $45,500 [the same as (g)]. k. $120,500 ($75,000 + $45,500) or (i + j) l. $225,500 ($105,000 + $120,500); also the same as total assets. m. $57,500 ($125,000 $67,500) n. $105,000 (See notes payable on the balance sheet.) o. $180,000 ($75,000 + $105,000) p. $168,000 ($180,000 $12,000) q. $50,500 ($57,500 $175,000 + $168,000) r. $0 (December was the first month of operation.) s. $50,500 [the same as (h)]. 53

24 P All financial statements should contain the name of the business in their heading. The retained earnings statement is incorrectly headed as Angela Griffin rather than Alpine Realty, Inc. The heading of the balance sheet needs the name of the business. 2. The income statement, retained earnings statement, and statement of cash flows cover a period of time and should be labeled For the Month Ended July 31, 20Y8. 3. The year in the heading for the retained earnings statement should be 20Y8 rather than 20Y7. 4. The balance sheet should be labeled as of July 31, 20Y8, rather than For the Month Ended July 31, 20Y7. 5. In the income statement, the dividends should not be listed as an operating expense but should be included in the retained earnings statement. 6. In the income statement, the total operating expenses are incorrectly subtracted from the sales commissions, resulting in an incorrect net income amount. This also affects the retained earnings statement and the amount of retained earnings that appears on the balance sheet. 7. In the retained earnings statement, the net income should be presented, followed by the amount of dividends, which is subtracted from the net income to yield retained earnings as of July 31, 20Y8. 8. Notes payable should be listed as a liability on the balance sheet. 9. Land should be listed as an asset on the balance sheet. 10. The balance sheet assets should equal the sum of the liabilities and stockholders equity. 11. The cash payments for operating expenses have been omitted from the operating activities section of the statement of cash flows. 12. The cash flows from financing activities should not include retained earnings. In addition, the financing activities section should include cash received from issuance of capital stock and from the issuance of notes payable. Also, the cash paid for dividends should be included as a deduction to arrive at net cash flows from financing activities. 54

25 P2 6, Continued 13. Since this is Alpine Realty s first month of operation, the increase in cash for July should equal $32,000, the cash balance as of July 31, 20Y8. Corrected financial statements appear as follows: ALPINE REALTY, INC. Income Statement For the Month Ended July 31, 20Y8 Sales commissions... $60,000 Expenses: Office salaries expense... $20,000 Rent expense... 6,000 Automobile expense... 3,500 Miscellaneous expense... 1,500 Total operating expenses... 31,000 Net income... $29,000 ALPINE REALTY, INC. Retained Earnings Statement For the Month Ended July 31, 20Y8 Net income for July... $29,000 Less dividends during July... 2,000 Retained earnings, July 31, 20Y8... $27,000 55

26 P2 6, Concluded ALPINE REALTY, INC. Balance Sheet July 31, 20Y8 Assets Cash... $ 32,000 Land... 30,000 Total assets... $ 62,000 Liabilities Notes payable... $ 20,000 Stockholders Equity Capital stock... $15,000 Retained earnings... 27,000 Total stockholders equity... 42,000 Total liabilities and stockholders equity... $ 62,000 ALPINE REALTY, INC. Statement of Cash Flows For the Month Ended July 31, 20Y8 Cash flows from operating activities: Cash receipts from sales commissions... $ 60,000 Deduct cash payments for operating expenses... (31,000) Net cash flows from operating activities... $ 29,000 Cash flows used for investing activities: Cash payments for land... (30,000) Cash flows from financing activities: Cash receipts from issuance of capital stock... $ 15,000 Cash receipts from issuing notes payable... 20,000 Cash payments for dividends... (2,000) Net cash from financing activities... 33,000 Net increase in cash during July... $ 32,000 Cash as of July 1, 20Y Cash as of July 31, 20Y8... $ 32,000 56

27 FINANCIAL ANALYSIS FA Year 2 Year 1 Sales % 100.0% Cost of sales... (73.0) (71.7) Gross profit Operating expenses... (24.4) (25.5) Operating income Other income (expense): Interest expense... (0.6) (0.7) Tax expense... (0.8) (0.7) Other income Net income Safeway s financial performance declined slightly in Year 2. Cost of sales as a percent of sales increased 1.3% from 71.7% to 73.0%. This had the effect of decreasing gross profit as a percent of sales by the same amount (1.3%). The decrease in operating expense of 1.1% (25.5% 24.4%) offset the increase in cost of sales so that operating income decreased by only 0.2% (2.8% 2.6%). The other income and expense did not change significantly. Further investigation should be done as to what cost of sales increased in Year 2. The increase may be due to increasing cost of merchandise in which case Safeway might consider being more aggressive in passing on cost increases to customers through prices increases. FA2 2 In Year 1, operating income and net income were comparable for Safeway and Kroger. For example, Safeway had operating income of 2.8% of sales compared to Kroger s 2.7%. Likewise, Safeway had net income of 1.4% of sales compared to Kroger s 1.3%. However, Safeway s cost of sales and operating expenses as a percent of sales differ significantly. Safeway s cost of sales as a percent of sales of 71.7% in Year 1 and 73.0% in Year 2 are significantly less than Kroger s 77.8% in Year 1 and 79.1% in Year 2. However, Safeway s operating expenses of 25.5% in Year 1 and 24.4% in Year 2 are significantly more than Kroger s 19.6% in Year 1 and 19.5% in Year 2. These results should be investigated and provide opportunities for both companies to improve their operations. For example, Kroger should explore why its cost of sales are higher than Safeway s cost of sales, and Safeway should explore why its operating expenses are higher than Kroger s operating expenses. The other income and expense results are relatively insignificant and comparable. 57

28 FA Year 2 Year 1 Sales % 100.0% Cost of sales... (58.7) (57.3) Gross profit Operating expenses... (26.3) (26.6) Operating income As a percent of sales, Kellogg's operating income decreased from 16.1% in Year 1 to 15.0% in Year 2. In Year 2, operating expenses as a percent of sales decreased by 0.3 percent from 26.6 in Year 1 to The primary cause of the decrease in operating income in Year 2 was the increase of 1.4% in the cost of sales from 57.3% in Year 1 to 58.7% in Year 2. This increase should be investigated as to its cause, and it should be determined whether the increase should be passed on to customers. FA Year 2 Year 1 Sales % 100.0% Cost of sales... (63.7) (60.0) Gross profit Operating expenses... (20.9) (21.4) Operating income As a percent of sales, General Mill's operating income decreased from 18.6% in Year 1 to 15.4% in Year 2. In Year 2, operating expenses as a percent of sales decreased by 0.5 percent from 21.4 in Year 1 to The primary cause of the decrease in operating income in Year 2 was the increase of 3.7% in the cost of sales from 60.0% in Year 1 to 63.7% in Year 2. This increase should be investigated as to its cause, and it should be determined whether the increase should be passed on to customers. 58

29 FA2 5 In Year 2, operating income as a percent of sales is comparable for Kellogg (15.0%) and General Mills (15.4%). The primary differences between the two companies involve operating expenses and cost of sales. Operating expenses as a percent of sales for Kellogg are 26.3%, which is 5.4% higher than the 20.9% of General Mills. In contrast, cost of sales as a percent of sales for Kellogg is 58.7%, which is 5.0% lower than the 63.7% of General Mills. The net of these effects is that General Mills has a slightly higher operating profit as a percent of sales than Kellogg. These results provide opportunities for both companies to improve their operations. For example, Kellogg should explore why its operating expenses are higher than General Mills, and General Mills should explore why its cost of sales is higher than Kellogg s. Note: Comparison of Year 1 common-sized income statements provide similar conclusions. 59

30 FA Year 2 Year 1 Current assets: Cash % 6.3% Accounts receivable Inventories Prepaid and other assets Total current assets Fixed assets: Property, plant, and equipment Intangibles Other assets Total fixed assets Total assets % 100.0% Current liabilities: Accounts payable % 18.0% Salaries and wages payable Debt due within one year Other liabilities Total current liabilities Long-term liabilities: Debt and other financing obligations Other liabilities Total long-term liabilities Total liabilities Stockholders Equity Capital stock Retained earnings Other equity items... (34.7) (28.6) Total stockholders equity Total liabilities and stockholders equity 100.0% 100.0% 2. A comparison of assets for Years 1 and 2 does not indicate any significant change in the mix of assets. Current assets have decreased 1.2% as a percent of total assets while fixed assets have increased by the same amount. A comparison of liabilities for Years 1 and 2 indicates an increase in both current and long-term liabilities as a percent of total liabilities plus stockholders equity. As a result, total liabilities have increased 5.7% of total liabilities plus stockholders equity. A corresponding decrease of 5.7% occurred in stockholders equity. This decrease in stockholders equity was caused primarily by other equity items, which includes the purchase of a company s stock by itself. Such stock is called Treasury Stock and is often purchased when a company feels its shares of stock are undervalued. Overall, Kroger appears to have a strong balance sheet with no major areas of concern. 60

31 CASES Case From our discussions in Chapter 1, the two possible business emphases that could be used are low-cost emphasis and premium-price emphasis. 2. Real-world examples of each emphasis are as follows: Low-cost emphasis: Ann Taylor, SteinMart, Walmart, Kmart, Costco Premium-price emphasis: GAP, The Limited, Talbots 3. The answers will vary among the student groups. Normally, venture capital firms demand a large percentage of ownership, which may be the majority (over 50%) ownership. Case 2 2 Dr. Turner s comment is not correct. The difference in the cash balance of $55,000 ($100,000 $45,000) represents the net result of operating, investing, and financing cash activities. To determine the profit, the effects of Dr. Turner s investing and financing activities would also need to be considered. For example, Dr. Turner might have invested in buildings, land, computer equipment, or software programs that would be classified as investing activities. Also, Dr. Turner may have borrowed cash from a bank or withdrawn cash from SickCo as dividends. 61

32 Case 2 3 Year 1 Year 2 Year 3 Net cash flows from operating activities negative positive positive Net cash flows from investing activities negative negative negative Net cash flows from financing activities positive positive positive Start-up companies normally experience negative cash flows from operating and investing activities. Also, start-up companies normally have positive cash flows from financing activities from raising capital. Case 2 4 Note to Instructors: The objective of this case is to familiarize students with financial reporting resources available on the Internet. The following solution is based upon the Apple Inc. data as of June 19, 2013, from Yahoo.com s finance Web site. 1. $ (See opening page for AAPL) 2. $ to $ (See opening page for AAPL) 3. September 21, 2012, at a price of $ (See Key Statistics) ,116 shares (net) were sold and purchased in the last 6 months ending June 19, (See Insider Transactions) 5. Timothy D. Cook; he is 52 years old. (See Profile) 6. $4,170,000 (See Profile) 7. $12.20 (See Key Statistics) 8. Strong Buy = 19 Buy = 23 Hold = 13 Sell = 1 Strong Sell = 1 Average broker recommendation is 2.0 (See Analyst Opinion) 9. $50,856,000,000 (See Financials: Cash Flows) % (See Key Statistics) 62

33 Case 2 5 Note to Instructors: The purpose of this case is to make students aware of alternative sources of information useful for investment decisions. 1. Although some may disagree, most would characterize the article as unfavorable concerning Apple s prospects for the future. 2. No. It would be unwise to sell Apple Inc. stock based only upon this article. Other information would include analysts recommendations and Apple Inc. s published financial statements. 3. No. Other sources of information should also be obtained, such as analysts recommendations, current newspaper articles concerning the company, and statements by the company s management. 4. Analysts use a variety of sources of information in making investment decisions and recommendations. In addition to published financial statements, analysts rely upon statements and interviews with management, economywide data, industry trends, consumer trends, newspaper articles, etc. 63

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